De Vaulx says he has spoken to fund managers who view fully invested requirements as a barrier to optimal investment decision making. "Instead of going to cash, they have to disguise such a move by investing in electric utilities or food companies," he says.
Addressing the contention that funds that move into short-term securities should lower their management fees, de Vaulx notes, "We are not getting a management fee to hold cash. We are getting it to make the decision about when it is appropriate, or not appropriate, to buy stocks or bonds." The manager cites mutual fund consultants as the major force behind the mandate to stay fully invested, and regrets that funds have become "an industry centered around asset gathering, not money management."
Some financial advisors believe that fund companies should consider a more flexible stance on the issue. "By and large, the industry puts too much pressure on managers to be fully invested," says Dan Roe, a financial advisor with Budros, Ruhlin, & Roe in Columbus, Ohio. "There is still a fear of looking different than your peer group, or deviating from your benchmark index."
Roe says he has softened his views on the issue over the last couple of years. "We used to be more sensitive to how much cash a manager was holding, but we've moved away from the style purist mentality to a certain extent," he says.
The recent change in thinking came after the manager of an aggressive small-cap mutual fund his firm owned shifted some money to cash in 1999 and 2000 because valuations were too high, a move that helped cushion the sharp bear market decline. "I consider that to be implementing valuation principles, not market timing," says Roe.
He adjusts for a fund's cash position at the portfolio level by taking it into account when crafting a financial plan or rebalancing. "If a client has a large allocation with an active manager who has a lot of cash on hand, we will adjust the client's asset allocation accordingly," he says. "In cases where it looks like we are overweight in small-cap stocks, we'll explain that the fund has raised cash and that we do not need to do it ourselves." In some cases, he says, the client can avoid capital gains taxes that come with selling appreciated fund shares and moving into money market securities if the fund manager builds cash instead.
Lou Stanasolovich, CEO at Legend Financial Advisors in Pittsburgh, says he does not mind holding a fund with a large cash stash as long as it is there for what he considers the right reasons. "It's okay if a fund has a large cash balance because the manager does not see anything out there that meets his buying standards," he says. "You need to distinguish that from situations where a fund is growing rapidly and should really shut down, or when a manager engages in market timing."
He believes that the need to stay fully invested forces some managers to engage in what he calls style or "cap drift." "Bill Miller [the long-time manager of Legg Mason Value Trust] built most of his track record in small- and mid-cap names. Then, when money started pouring into the fund, he started taking large companies into the fund so he could stay fully invested," Stanasolovich says.
While Stanasolovich believes the industry should give managers more discretion to stay on the sidelines, he believes some boundaries are appropriate. "Having half of a fund in cash is way too much," he says. "I can live with around 20%. If it gets over 30%, I would be a little concerned." And, he adds, a large cash allocation should be a relatively short-term event that lasts a year or two at most.